A Necessary Boost Section 32A Protections Qua RBI’s Prudential Framework

The Prudential Framework is a key tool for lenders to achieve timely stabilisation of stressed assets and improve credit circulation in the market.

On December 28, 2019, the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2019 (“2019 Ordinance”), was promulgated inter alia to “fill critical gaps in the corporate insolvency framework” in the Insolvency and Bankruptcy Code, 2016 (“Code”).¹ Section 32A, a statutory protection to the corporate debtor from liability for prior offences was explicitly provided upon the successful resolution resulting in change of management, was inserted therein.² In the meanwhile, on July 7, 2019 the Reserve Bank of India (“RBI”) also issued the Reserve Bank of India (Prudential Framework for Resolution of Stressed Assets) Directions 2019 (“Prudential Framework”) in exercise of powers under the Banking Regulation Act, 1949 (“BR Act”), “with a view to providing a framework for early recognition, reporting and time bound resolution of stressed assets”. The Prudential Framework contemplates resolution of stressed accounts by specific lenders, enumerated in Clause 3 thereof, including banks and non-banking financial companies. The Prudential Framework inter alia provides for the process, procedure and mechanism which the lenders should follow for implementing a resolution thereunder.

The essential object of early recognition of stressed assets and their effective resolution for value maximisation is fundamental to both the Code and the Prudential Framework. However, a protection akin to Section 32A is conspicuous by its absence in the Prudential Framework, which raises both policy and legal concerns on the efficacy of the Prudential Framework as a resolution mechanism, both for lenders and prospective resolution applicants.

Aims and objectives of the Code and the Prudential Framework

The Code is a beneficial legislation aimed at reviving and resolving insolvent corporate debtors through a creditor-controlled process to maximise value for all stakeholders. The Supreme Court in Swiss Ribbons Pvt. Ltd. & Anr. v. Union of India & Ors.,³ while upholding the constitutionality of the Code, also specifically highlighted that the key effect of initiating corporate insolvency resolution processes (“CIRP”) under the Code is the divestment of management and control of the corporate debtors away from persons who were responsible for the debt beleaguered state of affairs of the corporate debtor which necessitated the initiation of the CIRP in the first place.⁴

The Prudential Framework too, is an enabling framework for the “early recognition, reporting and time bound resolution of stressed assets.”⁵ It enables restructuring and resolutions outside the Code as well as encourages the use of the Code as a restructuring tool⁶ and is driven jointly by creditors. The Prudential Framework contemplates specific timelines within which lenders must take action in case of defaults and implement the resolution plan in a timebound manner.

The Prudential Framework mirrors the Code’s objectives and spirit of reorganisation, value maximisation and promotion of entrepreneurial spirit. Like the Code, the Prudential Framework contemplates a creditor-driven process⁷ for rehabilitation and continuation of a stressed borrower by restructuring its debt even before a default. In fact, the substantive guardrails in the Code, are categorically reflected in the Prudential Framework. Illustratively, restrictions under Section 29A are applicable to prospective resolution applicants even under the Prudential Framework⁸ and dissenting lenders are entitled to not less than the liquidation value, similar to Section 30(2) of the Code.⁹ Thus, the Prudential Framework tests well against the longstanding principles of insolvency resolution, and allocates risk among participants in a market economy in a predictable, equitable, and transparent manner,¹⁰ and presents as a viable out-of-court alternative to a CIRP under the Code.

Hence, the aim and object of both the Code and the Prudential Framework are self-same. The unity in the object as well as the resolution mechanisms provided in the Code as well as the Prudential Framework provide a justification to extend the protections under Section 32A to resolutions conducted under the Prudential Framework, where there is a change in ownership of the borrower.

Rationale underlying Section 32A

Contemporaneous with the enactment of Section 32A, the Report of the Insolvency Law Committee (February 2020) highlighted that continuation of liability for prior offences of the corporate debtor after resolution was an impediment to a robust and effective Indian corporate insolvency resolution framework which hampered the Code’s ultimate objective of optimising value in a CIRP. The Committee noted this could substantially lower the chances of its successful takeover and disincentivise entrepreneurship, which is antithetical to the objectives of the Code. Therefore, the Committee felt that a distinction must be drawn between the corporate debtor which may have committed offences under its previous management, prior to the CIRP, and a resolved corporate debtor taken over by an unconnected resolution applicant.

In this regard, the Sixth Report of the Standing Committee of Lok Sabha (March 2020) dated March 6, 2020 (“LS Report”) also set out that such a protection was essential for providing “the Resolution Applicant(s) a fair chance to revive the unit which otherwise would directly go into liquidation”¹¹ without imposing additional liabilities on its new management for acts committed by the erstwhile management. Pertinently, the LS Report highlighted the Ministry of Corporate Affairs’ rationale for introduction of such a provision was that upon the induction of a new management, the “corporate debtor is now fundamentally not the same entity as the one that committed the crime.”¹²

The Supreme Court, in Manish Kumar v. Union of India,¹³ while upholding the constitutional validity of Section 32A, observed that in the absence of such protection, resolution plans would not be forthcoming, and the Code’s objective of value maximization would be rendered nugatory. While Section 32A now finds a place in the statutory framework, it is a recognition of well accepted legal principles. The National Company Law Appellate Tribunal (NCLAT) in JSW Steel Ltd. and Ors. v. Mahender Kumar Khandelwal and Ors,.¹⁴ while dealing with the issue of whether the Enforcement Directorate (ED) could attach the properties of the corporate debtor after the resolution plan had been accepted for change in control in light of Section 32A, held that Section 32A was “clarificatory” in nature, and that the principle that such protections/ immunity are generally provided in a resolution process was already recognized even before Section 32A was enacted.¹⁵ This was the basis for the NCLAT to hold that Section 32A would operate even retrospectively to all resolution plans submitted prior to the 2020 Amendment.

The rationale of Section 32A can be therefore understood as follows. One, that pursuant to a CIRP involving a change in management, a corporate debtor undergoes a fundamental change of identity. On first principles, no person ought to be punished for violations not committed by him, and therefore, neither the new management nor the resolved corporate debtor must be injured with such penalty, especially in the context of insolvency resolution. Two, these immunities afford prospective resolution applicants the comfort that their investment into and association with a corporate debtor is protected from penalties and regulatory action, if they meet the test of Section 29A of the Code. This incentivises prospective resolution applicants to offer more value in resolution and furthers the Code’s objective of value maximisation.

A case for applying Section 32A for resolutions under Prudential Framework

A reading of the Prudential Framework clearly reveals parallels with the Code’s effect and objectives. Consequently, while examining the applicability of Section 32A like immunity to the Prudential Framework, the same principles and rationale ought to apply where there is a change in management. Injuring the property of the borrower company with penalty and enforcement action would be unreasonable, arbitrary and unfair for the very same reasons.

The protections of Section 32A therefore ought to be available under the Prudential Framework as upon induction of a new management, the corporate debtor is fundamentally not the same entity as the one that committed the offence as is the case with a resolution under the Code. Given the clarificatory nature of Section 32A, as also held by NCLAT¹⁶, the immunity it offers must be read into the Prudential Framework as well provided there is a change in the borrower’s management.

That said, a CIRP is a court monitored process, whereas the Prudential Framework contemplates a pre-emptive, lender-driven process for stabilisation of stressed assets before approaching the courts. A resolution under the Prudential Framework, without recourse to the CIRP route, may also result in a change in ownership, management and control of the borrower, there is admittedly no judicial scrutiny before approval of a resolution plan especially with reference to compliance with the Section 29A eligibility criteria.

However, Clause 24 of the Prudential Framework, mandates lenders to conduct “necessary due diligence … and clearly establish that the acquirer is not a person disqualified in terms of Section 29A of the IBC” and other applicable law, and establish that the prospective resolution applicant is not related to the erstwhile management of the defaulter, and is a completely new entity which changes the ownership, management and control of such defaulter. A resolution that does not meet the above requirements can be challenged by the relevant authorities and any protections akin to those under Section 32A can be withdrawn. Accordingly, notwithstanding the absence of a judicial order confirming the plan approved by lenders under the Prudential Framework, the principles of Section 32A can be made applicable to resolutions under the Prudential Framework.

Concluding thoughts

The Prudential Framework is a key tool for lenders to achieve timely stabilisation of stressed assets and improve credit circulation in the market. Debt laden companies under resolution have attracted investments both under the Code and the Prudential Framework in the recent years. Extending equal protection to resolution applicants under the Prudential Framework can improve chances of stabilising stressed assets and provide lenders with earlier resolutions, while reducing the burden on the NCLT benches, and eventually, promote ease of doing business.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.